Perf. Comp. Markets
Profit Maximization
Produce or Shut Down
Entry/Exit in Long Run
Long-Run Equilibrium
Chapter 12.
Firms in Perfectly Competitive Markets
Instructor: JINKOOK LEE
Department of Economics / Texas A&M University
ECON 202 504
Principles of Microeconomics
Efficiency
Perf. Comp. Markets
Profit Maximization
Produce or Shut Down
Entry/Exit in Long Run
Breakfast Market
Long-Run Equilibrium
Efficiency
Perf. Comp. Markets
Profit Maximization
Produce or Shut Down
Entry/Exit in Long Run
Breakfast Market
Long-Run Equilibrium
Efficiency
Perf. Comp. Markets
Profit Maximization
Produce or Shut Down
Entry/Exit in Long Run
Breakfast Market
Long-Run Equilibrium
Efficiency
Perf. Comp. Markets
Profit Maximization
Produce or Shut Down
Entry/Exit in Long Run
Breakfast Market
Long-Run Equilibrium
Efficiency
Perf. Comp. Markets
Profit Maximization
Produce or Shut Down
Entry/Exit in Long Run
Long-Run Equilibrium
Four Market Structures
We can divide market structure by three key characteristics.
The number of firms in the industry
The similarity of the good produced by the firms in the industry
The ease with which new firms can enter the industry
Four Market Structures
Efficiency
Perf. Comp. Markets
Profit Maximization
Produce or Shut Down
Entry/Exit in Long Run
Long-Run Equilibrium
A Perfectly Competitive Markets
A perfectly competitive firm cannot affect the market price.
prices are determined by the interaction of demand and supply.
the actions of any single consumer (or firm) have no effect on the
market price.
buyers and sellers are Price taker.
Why?
a firm is very small relative to the market.
it is selling exactly the same product as every other firm, thus it can
sell as much as it wants without having to lower its price.
if a firm raise its price, consumers will switch to buying the product
from the firm’s competitors.
Efficiency
Perf. Comp. Markets
Profit Maximization
Produce or Shut Down
Entry/Exit in Long Run
Long-Run Equilibrium
Demand Curve for a Perfectly Competitive Firm
Demand curve for a firm’s output is a horizontal line.
a firm can sell as much as it wants at the current market price
but it cannot sell anything at all if it raises the price by even 1 cent.
Demand and Supply for Market
Demand for a Firm
Efficiency
Perf. Comp. Markets
Profit Maximization
Produce or Shut Down
Entry/Exit in Long Run
Long-Run Equilibrium
Efficiency
Revenue for a Firm in a perfectly Competitive Market
Farmer Parker’s objective is to maximize profit. To do so, he should decide
maximizing quantity of wheat.
Profit: Total revenue minus total cost (Profit = TR − TC )
Total revenue (TR): total amount a firm receives
TR = P × Q
Average revenue (AR): Total revenue divided by the quantity of the
product sold.
AR =
TR
Q
=
P×Q
Q
=P
Marginal revenue (MR): The change in total revenue from selling one
more unit of a product.
MR =
∆TR
∆Q
Perf. Comp. Markets
Profit Maximization
Produce or Shut Down
Entry/Exit in Long Run
Long-Run Equilibrium
Efficiency
Revenue for a Firm in a perfectly Competitive Market
Farmer Parker’s objective is to maximize profit. To do so, he should decide
maximizing quantity of wheat.
For a firm in a perfectly competitive market, price is equal to both average
revenue and marginal revenue (P = AR = MR).
Perf. Comp. Markets
Profit Maximization
Produce or Shut Down
Entry/Exit in Long Run
Long-Run Equilibrium
The Profit-Maximizing Level of Output
Efficiency
Perf. Comp. Markets
Profit Maximization
Produce or Shut Down
Entry/Exit in Long Run
Long-Run Equilibrium
The Profit-Maximizing Level of Output
Once more, optimal decisions are made at the margin.
The profit-maximizing level of output is where..
the difference between total revenue and total cost is the greatest.
marginal revenue equals marginal cost, or MR = MC .
For a firm in a perfectly competitive industry, price is equal to marginal
revenue (P = MR).
we can restate the MR = MC condition as P = MC .
Efficiency
Perf. Comp. Markets
Profit Maximization
Produce or Shut Down
Entry/Exit in Long Run
Long-Run Equilibrium
Profit on the Graph
Profit can be re-written as follows,
Profit = TR − TC = (P × Q) − (ATC × Q) = (P − ATC ) × Q
Thus, profit is equal to the quantity (Q) produced multiplied by the
difference between price (P) and average total cost (ATC).
Efficiency
Perf. Comp. Markets
Profit Maximization
Produce or Shut Down
Entry/Exit in Long Run
Long-Run Equilibrium
Break-even and Loss
The optimal condition (MR = MC ) does not guarantee that the firm
actually make a profit.
1
2
3
P > ATC : the firm makes a profit
P = ATC : the firm breaks even (total revenue=total cost).
P < ATC : the firm experiences a loss.
in this case, maximizing profit amounts to minimizing loss.
Efficiency
Perf. Comp. Markets
Profit Maximization
Produce or Shut Down
Entry/Exit in Long Run
Long-Run Equilibrium
Efficiency
Produce or Shut Down in the Short Run
Why would a firm continue to produce even though it was operating at a
loss?
Even if a firm decides to shut down, the firm must still pay its fixed costs.
in most cases, fixed costs are sunk costs.
Sunk cost: a cost that has already been paid and cannot be recovered.
Thus, if the firm can reduce its loss below the amount of its fixed cost, the
firm will continue to produce.
this happens when total revenue is greater than variable costs.
When total revenue is less than variable costs, the firm will shut down.
producing would cause it to lose an amount greater than its fixed costs.
loss from fixed costs is the maximum the firm will accept.
Perf. Comp. Markets
Profit Maximization
Produce or Shut Down
Entry/Exit in Long Run
Long-Run Equilibrium
Supply Curve of a Firm in the Short Run
A firm will produce at the level of output where MR = MC (or P = MC ).
that is, the marginal cost curve for a firm tells us how many units of a
product the firm is willing to sell at any given price.
Thus, a perfectly competitive firm’s marginal cost curve also is its supply
curve.
But a firm will shut down if its total revenue is less than its variable cost
P × Q < VC
P < AVC
So, the firm’s marginal cost curve is its supply curve only for prices at or
above average variable cost.
Efficiency
Perf. Comp. Markets
Profit Maximization
Produce or Shut Down
Entry/Exit in Long Run
Long-Run Equilibrium
Efficiency
Supply Curve of a Firm in the Short Run
Shutdown point: The minimum point on a firm’s average variable cost
curve
if the price falls below this point, the firm shuts down production in the
short run.
A Firm’s Short-Run Supply Curve
Perf. Comp. Markets
Profit Maximization
Produce or Shut Down
Entry/Exit in Long Run
Long-Run Equilibrium
Efficiency
Market Supply Curve in a Perfectly Competitive Industry
We can derive the market supply curve by adding up the quantity that each
firm in the market is willing to supply at each price.
Individual firm supply
Market supply
Perf. Comp. Markets
Profit Maximization
Produce or Shut Down
Entry/Exit in Long Run
Long-Run Equilibrium
Economic Profit and the Entry/Exit Decision
Economic profit: A firm’s revenues minus all its costs (implicit and
explicit).
Farmer Gillette’s Costs (per year)
In the long run, unless a firm can cover all its costs, it will shut down and
exit the industry.
recall that in the long run, there is no fixed cost.
Efficiency
Perf. Comp. Markets
Profit Maximization
Produce or Shut Down
Entry/Exit in Long Run
Long-Run Equilibrium
Efficiency
Economic Profit Leads to Entry of New Firms
Suppose that Farmer Gillette earns an economic profit (S1 , D), and that
other farmers are just breaking even by selling their carrots to supermarkets.
Farmers will continue entering the market until the market supply curve
has shifted from S1 to S2 .
Eventually, farmers in the market will return to break even.
Perf. Comp. Markets
Profit Maximization
Produce or Shut Down
Entry/Exit in Long Run
Long-Run Equilibrium
Economic Losses Lead to Exit of Firms
Suppose that market demand curve shift to the left, from D1 to D2 .
it reduces the market price to $7 per box.
Gillette’s demand curve shifts down from MR1 to MR2
at a market price of $7 per box, farmers have economic losses
some farmers will exit the market, which shifts the market supply curve to
the left.
Efficiency
Perf. Comp. Markets
Profit Maximization
Produce or Shut Down
Entry/Exit in Long Run
Long-Run Equilibrium
Efficiency
Economic Losses Lead to Exit of Firms
Exit continues until the supply curve has shifted from S1 to S2
the market price has risen from $7 back to $10.
with the price back at $10, Farmer Gillette will break even.
In the new market equilibrium, total sales of carrots in farmers’ markets have
fallen from 310,000 to 270,000 boxes.
Perf. Comp. Markets
Profit Maximization
Produce or Shut Down
Entry/Exit in Long Run
Long-Run Equilibrium
Efficiency
Long-Run Equilibrium
Long-run competitive equilibrium: The situation in which the entry and
exit of firms has resulted in the typical firm breaking even.
The long-run average cost curve shows the lowest cost at which a firm is
able to produce a given quantity of output in the long run.
So, we would expect that in the long run, competition drives the market
price to the minimum point on the typical firm’s long-run average cost
curve.
Perf. Comp. Markets
Profit Maximization
Produce or Shut Down
Entry/Exit in Long Run
Long-Run Equilibrium
The Long-Run Supply Curve
Long-run supply curve: A curve that shows the relationship in the long
run between market price and the quantity supplied.
the long-run supply curve is a horizontal line.
Efficiency
Perf. Comp. Markets
Profit Maximization
Produce or Shut Down
Entry/Exit in Long Run
Long-Run Equilibrium
Efficiency
Productive Efficiency
Productive efficiency: The situation in which a good or service is
produced at the lowest possible cost.
The forces of competition will drive the market price to the minimum
average cost of the typical firm.
As we have seen, perfect competition results in productive efficiency.
Managers of firms strive to earn an economic profit by reducing costs, but
in a perfectly competitive market, other firms quickly copy ways of reducing
costs.
Therefore, in the long run, only the consumer benefits from cost reductions.
Perf. Comp. Markets
Profit Maximization
Produce or Shut Down
Entry/Exit in Long Run
Long-Run Equilibrium
Efficiency
Allocative Efficiency
Allocative efficiency: A state of the economy in which production
represents consumer preferences; in particular, every good or service is
produced up to the point where the last unit provides a marginal benefit to
consumers equal to the marginal cost of producing it.
Firms will supply all those goods that provide consumers with a marginal
benefit at least as great as the marginal cost of producing them because:
The price of a good represents the marginal benefit consumers receive from
consuming the last unit of the good sold.
Perfectly competitive firms produce up to the point where the price of the
good equals the marginal cost of producing the last unit.
Therefore, firms produce up to the point where the last unit provides a
marginal benefit to consumers equal to the marginal cost of producing it.